Meaningful disclosure

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‘Hedge funds are leveraged investment vehicles whose opaqueness and risk makes them unsuitable to most institutional investors.” Just like the failure of traditional active management to add value, and the superiority of equities over bonds, financial commentators look at this as one of investment management’s empirical, self-evident truths and happily provide a regular supply of news, facts and anecdotes apparently confirming it.
How is it then that 30% of the new money inflow into US hedge funds comes from institutions? Or that in a survey of the top 100 European pension funds in 2001, 56% of respondents already invest, or plan to invest shortly in hedge funds? Of course investing in hedge funds may just be fashionable – as it also was back in the late 1960s, in the early 1990s, and in 1996–97. But equally surely there must be more to them for so many pension funds, endowments and foundations to overcome general scepticism and invest.
This is a brief account of an attempt to bridge the gap between hedge funds and institutional investors in a very simple way: by letting them talk to each other. By raising and debating issues on disclosure, reporting and transparency that they consider relevant, institutional investors show a keen interest in understanding what hedge funds are really about and whether they are a suitable investment form. At the same time the discussion helps hedge fund managers to come of age and accept a degree of operational and investment risk infrastructure to meet the challenges and reap the rewards of institutional investments.
This effort began in early 2000 when a group of mostly US-based hedge fund managers, funds of hedge funds, and institutional investors met under the auspices of the Investor Risk Committee (IRC), a group that promotes understanding of risk-related issues in investment management. The discussion topic was: “What is the right level of disclosure for hedge funds?” To the surprise of many, including perhaps some of the attendees, these two very different groups of people quickly agreed on a number of key points. It was soon determined that the objective was to balance risk monitoring, risk aggregation across investments and strategy drift monitoring, with the need to protect investors’ capital. One of the group’s key findings was on the necessary degree of disclosure. Traditional views on hedge funds hold that only full position-level disclosure would guarantee a proper level of monitoring and risk management of hedge fund investments. Despite the fact that many of them receive full position disclosure for many of their investments, the members of the IRC were in agreement that full position-level disclosure was not the answer. The harm that full position disclosure could cause for many common hedge fund strategies will be adverse to both the investment manager and to investors. In addition, institutions expressed concern over the operational difficulties associated with processing such vast quantities of diverse data.
If summary risk information is sufficient, then the quality of information disclosed depends on a group of satisfactory and meaningful summary performance, risk and exposure measures. IRC members identified four dimensions to such measures: content, granularity, frequency, and delay.
Content describes the quality and sufficiency of coverage of the hedge fund manager’s activities. It covers information about the risk, return and positions on an actual as well as on a stress-tested basis. More specifically, summary measures of content suggested include value at risk (VAR), measures of gross and net exposures, correlations, concentration by geographic areas and asset class.
Granularity describes the level of detail. Examples are NAV disclosure, disclosure of key risk determinants, tracking error or other risk and return measures at the portfolio level, by region, by asset class, by duration, by significant holdings. Granularity is affected by the size of assets under management, so that a larger fund operating in a relatively less liquid market should be required to disclose less information. The general recommendation was that the top 10 long and short positions by asset class and geographic area should be disclosed.
Frequency describes how often the disclosure is made. High turnover trading strategies may require more frequent disclosure than private or distressed-debt investment funds where monthly or quarterly disclosure is more appropriate. On this point it is interesting to note that many industry professionals argue for a very frequent disclosure of performance and risk information – as frequently as weekly or even daily – due to the fast turnover of the portfolios of many hedge funds. IRC members concluded instead that, just like for many other traditional investments, monthly frequency is adequate in the majority of cases.
Finally, delay describes how much of a lag occurs between when the fund is in a certain condition and when that fact is disclosed to its investors. Summary statistics should be disclosed as soon as is practicable following the end of the reporting period (preferably within 10 days) subject to protecting the interests of investors from suffering adverse market impact from that disclosure.
The work of the IRC has now expanded through several meetings in the US and Europe, where senior members from the institutional investment community have joined to give their contribution to a debate that many of them consider necessary. As Thijs Coenen, head of risk management for the Dutch pension fund ABP Investments and steering group member of the IRC, recently commented: “As an investor in hedge funds, ABP is very much aware of the importance of developing ‘risk transparency’ standards for hedge funds without compromising investment performance.” And on the IRC effort: “We look forward to contributing to this and other issues that are key to the further professionalisation of the hedge fund investment industry.”
Indeed, while the findings expressed by IRC members have a global reach, the issues raised sometimes have differing relative importance for certain investor groups. European hedge fund investors seem to think that a meaningful disclosure process has to be seen within the context of information aggregation within the whole hedge fund portfolio. Again, in Coenen’s words: “The key to hedge fund risk factors is that they can be aggregated across an investor’s entire portfolio.” Indeed the present and future efforts of the European IRC meetings will concentrate on the issue of meaningful information aggregation.
Also of specific interest to European investors is the issue of transparency and disclosure of funds of hedge funds, both the one they receive from underlying hedge fund managers, and the one they give to investors. This is hardly surprising, perhaps, considering that the European way to invest in hedge funds seems to rely more heavily on funds of hedge funds than on single fund investment.
Is a world where hedge funds are subject to broadly agreed, meaningful requirements for performance reporting, transparency and disclosure likely to happen in the near future? The signs seem to be there for this to happen quite sooner that popular consensus on hedge funds would have us believe. Does this mean that the hedge fund world as a whole will conform to such standards? The answer is most probably not. The signs are already there that the market is bifurcating into hedge funds which go mainstream and accept that institutional-level transparency and investment necessarily go hand in hand, and others that will chose to limit the amount of information disclosed and remain mainly a vehicle for wealthy individuals and private banking investments. While there’s little doubt that the latter type of hedge funds will ensure that the source for the sort of articles on hedge funds that the financial press seems to like most will not dry up, institutionally oriented hedge funds will make it easier for pension funds and other institutions to have access to this asset class limiting the amount of unintended, non-investment related risk.
Giovanni Beliossi is European steering group head of the Investor Risk Committee. He is an associate director, hedge funds, with First Quadrant. A collection of IRC’s findings can be found at

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